Caught in the Middle with Nowhere to Go: The Battle Between Inflation and Deflation

Big news: oil closed over $100 for the first time ever yesterday.

Gold rose too - $27, to $929. Platinum shot up $89 to $2153. And the commodity index, the CRB, hit a new record of 535.17.

Stocks, meanwhile, held steady. The Dow fell 4 points.

What is happening?

Let's begin at the end. "Buy gold on dips...sell stocks on rallies." This has been our Trade of the Decade...and our advice since 2000.

Yesterday, we proposed a modest hypothesis. Caught in the crossfire between the forces of inflation and the armies of deflation, stocks have been immobilized. They "should" go down...but they are getting mixed signals. Deflation forces them to keep their heads down. But inflation prevents them from retreating. They are stuck.

Many analysts look at the inaction in the stock market and think they see growth and prosperity ahead. "If a recession were really on the way, surely the stock market would see it," they say. But stocks DO see it. It's just that they see something else coming from the other direction - inflation. They're caught in the middle - with nowhere to go.

Gold and oil see the same thing. On the one hand, deflation "should" drag them down too. On the other, inflation will surely boost them up. But they react differently than stocks. First, they are more global than the U.S. stock market. While the U.S. economy is slowing down, China, India and Latin America are still growing rapidly. Yes, they are bound to let up a bit as U.S. consumers stop buying so much, but they have their own buyers to take up...gradually...some of the slack.

And second, while the United States is the center of the deflationary economic slowdown, inflation is more of a worldwide phenomenon. Inflation rates in China, for example, are higher than they are in the United States. Prices of apartments in Buenos Aires...subway tickets in Paris...hamburgers in Singapore - everything is going up.

In the past, inflation has always had a national identity card. The inflation of the '20s was concentrated in Germany, where hyperinflation wiped out the middle class and set the country on the road to ruin. Investors...like Jewish refugees 10 years later...had to move their savings to France or England to escape it. Likewise, in Argentina, the inflation of the '80s was easily avoided - just put your money in a Miami bank.

Traditionally, the dollar was a haven for people wishing to protect themselves from inflation - even though the dollar itself was losing value rapidly . In 1935, a U.S. dollar had about the same purchasing power as a U.S. dollar from 1800. Then, it began a steep decline...erasing 95% of its value over the next 70 years. Still, people with money usually preferred to keep their money in dollars, rather than in...say...australs or zlotys. The dollar may have been losing value, but at least it was doing so in a gentle, "controlled" manner.

But times have changed. Now, there's a new kind of inflation - it is practically everywhere...in every country...and it risks spinning out of control. That is why gold is hitting new highs - against almost every currency...and every other market...in the world.

News came yesterday, that the Fed has quietly lent some $50 billion to member banks using a new method - an "auction facility" that allows banks to put up unconventional collateral. The government no longer reports a figure for M3, the broadest measure of the money supply, but shadow analysts say it is going up at 15% per year - about six times faster than GDP growth.

Most of this money ends up outside the United States. That's where most U.S. Treasury debt ends up too. The dollar is America's leading (and highest margin) export. This has forced foreign central banks to create more of their own currencies to buy up the dollars; otherwise they would face a competitive disadvantage, in that the dollar would fall against their local currencies, making their exports more expensive on the world market.

And so, the whole world is being smothered in paper. Paper dollars...paper euros...paper rand...paper cordobas...paper money of all sorts. Where can the investor go to get away from this paper? What can he buy to protect himself from inflation? How can he get some air?

That's right. Gold. And it's why this bull market in gold could be even bigger than the last one. Then, in the late '70s, it was primarily the U.S. dollar that suffered from inflation...and primarily Americans, and perhaps Arab oil exporters, who were buying gold. The Russians were still building cars that didn't run. The Chinese were still recovering from their Great Leap Forward of the '60s and dismantling their backyard steel mills. And the Indians weren't even awake yet.

Now, the whole world is different. It is full of more paper money than ever before...and full of billions of alert people who will want to protect themselves from it. They might try stocks...or property...or Rembrandts...but traditionally, the surest, simplest solution is gold.

For those of you out there thinking that the yellow metal is too expensive to buy now, you are halfway right. The current cost of gold is above the level that we would generally advise you to buy...but our friends at Outstanding Investments have told us of a way you can get gold out of the ground and into your portfolio - for a penny per ounce. No joke - and no shovel required.

Bill Bonner
The Daily Reckoning Australia

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